Saturday, March 17, 2012

Central to Old Monetarism - the Quantity Theory of Money - is the idea that we can define some subset of assets to be "money". Money, according to an Old Monetarist, is the stuff that is used as a medium of exchange, and could include public liabilities (currency and bank reserves) as well as private ones (transactions deposits at financial institutions). Further, Friedman in particular argued that one could find a stable, and simple, demand function for this "money," and estimate its parameters. Lucas does that exercise here, and then uses the estimated money demand function parameters to measure the costs of inflation.

What's wrong with that? The key problem, of course, is that the money demand function is not a structural object. Some central bankers, including Charles Goodhart, figured that out. Goodhart's idea is a bit subtle, but there are more straighforward reasons to think that the parameters we estimate as "money demand" parameters are not structural. First, all assets are to some extent useful in exchange, or as collateral. "Moneyness" is a matter of degree, and it is silly to draw a line between some assets that we call money and others which are not-money.

I challenged him on how important moneyness actually is in new monetarist literature. Why, for instance, do so many new monetarist papers include some variable M if money is a matter of degree? You can't represent the idea "as a matter of degree" with a variable called M which by definition excludes all non-M assets. If you do so, you're already drawing lines between assets.

He never really responded to me. Steve, any thoughts? You've got the floor.

Although they have a better grasp on how the ISA works than most, the authors Michiel Bijlsma and Jasper Lukkezen do make an important error:

The important difference between Target 2 and ISA, however, is that in the US all Reserve Banks are owned by the federal government. This means that in the US it is possible to safeguard the integrity of the system by changing the settlement rules. This is as exciting as a game of monopoly among friends. As all Federal Reserve banks are owned by the federal government, a loss in Richmond is irrelevant when there is an equal gain in New York. In the Eurozone, however, the ECB is owned by the national governments via the national central banks, not by the European Union as a whole. When one would change the settlement rules here – for example by discounting claims – this means a transfer across countries.

In actuality, all twelve Federal Reserve district banks are owned by their member private banks. What allows the Fed to change settlement rules is not any ownership position in the Fed (they have none) but the system's constituting articles, or Federal Reserve Act, which put the preservation of the par value of US dollar-denominated banking liabilities above the necessity of the system settling.

As I pointed out in response to commenter John Wittaker here, if the Federal Reserve system was to be dissolved and there existed significant imbalances between districts, final settlement might not be guaranteed. That's because a district Fed's credit is only as good as the credit of its member private banks. If these member were asked to re-capitalize the district bank to enable it to achieve settlement, but they were unable to do so, it would cause problems.

So in that respect, Bijlsma and Lukkezen are wrong to say that a loss in Richmond and a gain in New York is ultimately irrelevant. When all the chips are down, these imbalances represent transfers between shareholders of district Reserve banks. For instance, if the Richmond Fed failed to settle and its shareholders, including Bank of America, could not support a recapitalization of that district, then the New York Fed would have a massive loss on its hands. This would require member banks like JP Morgan to re-capitalize it. Thus, in comparing the ECB settlement mechanism to the Federal Reserve mechanism, it's not fair to say transfers do not occur - all that can be said is that these transfers are distributed across a different spectrum of actors.

Bijlsma and Lukkezen also have a similiar article here though they don't attribute to the Money View credit for the initial observation nor myself for the underlying research. They note:

Every year in April the average ISA balance over the past 12 months is calculated and netted via transfer of gold certificates between reserve banks.

This also is not entirely correct. Settlement via SOMA transfers, not gold certificates, has been the standard operating procedure since the 1970s.

In short, I disagree with him. If you do the security analysis, central bank issued notes and deposits are unsecured senior perpetual liabilities with a limited floating conversion feature attached to them. Most people don't perceive them as such because in the normal course of life they only experience these liabilities as pure means-of-exchange. Only those individual's with a banker or investor's mentality treat central bank issued notes and deposits. Either way works - what is interesting is how these two mentalities weave together to create an integrated store-of-value and medium-of-exchange approach to understanding money.

Nick also tries to re-conceptualize central bank issued money as put options. This money can be "putted" for CPI. I like this idea. Because I see central bank issued notes and deposits as liabilities, I prefer the analogy to convertible bonds. Convertibility is really just an option feature added on to a liability like a bond, deposit, or note. How does this convertibility work? The Bank of Canada, for instance, will conduct sale and repurchase operations (SRAs) - selling bonds for cash - should the overnight fall below its target. Banks have the option in this case to convert their deposits into the underlying. This is a floating rate because over time the Bank will change the note-to-bond conversion price.

Saturday, March 10, 2012

Lars Christensen had some interesting comments and responses on market monetarism.

I pushed him on how far market monetarists departed from traditional monetarists in admitting that money creation was endogenous, not exogenous. ie. determined by the central bank. If this is indeed the case, than the market monetarists stand nearer to the middle of the historic currency vs. banking school divide than Milton Friedman did. The latter would be considered a pure currency school theorist. Same with Mises and the traditional Austrians, although the Austrian free-bankers are surely not currency school theorists.

The fact that market monetarists, according to Christensen, are willing to think about money endogenously, just as the banking school theorists did, is a healthy improvement.

In the comments I eventually disagree. If the hypothesis is true, it should apply to equity markets. But Nick can't provide a measure of price stickiness in equity markets. I for one have don't know what a "sticky" stock is. My hunch, guided by experience, is that bids and offers for stock X will react almost as quickly to news and events as those for stock Y.

But stocks are certainly more or less liquid. So you can have varying grades of liquidity without varying grades of stickiness. Thus, the two concepts aren't related.

There are plenty of interesting comments there on how this would work. In particular, how would the Icelandic banks secure liquidity if they were to move to a Canadian dollar standard? It seems to me that local Canadian banks could act as lenders of last resort to the Icelandic banking system.

Alternately, if Icelandic banks were willing to submit to Canadian regulation, then perhaps things could proceed one step further and get admittance to the Canadian Payments Association, Canada's central clearing system. As members they would get Bank of Canada lender of last resort assurance.